Alasdair Macleod – 28 May 2009
Bond market commentators are now aware that the likely size of government bond issuance is undermining prices, with the yield on the US long bond having risen from a low of 2.52% to 4.36% in the last five months. This rise has occurred in spite of the most deflationary outlook since the 1930s. It has also been reflected by increases in yield in other government bond markets.
But why should this happen, when the Congressional Budget Office forecast numbers are so benign? The following table is an extract:
In support of the CBO’s optimistic view, market sentiment has improved greatly since March, and this is reflected in multifarious indicators, from money-market spreads to confidence surveys. The improvement in sentiment needs to be put in context. It originated from exceptionally acute financial pessimism and raw money has now been pumped into the economy. An inventory over-hang has been cleared at bargain prices, and the inevitable re-stocking is the one-off reason for the pick-up in business activity, The overall effect has been enhanced by cunning official spin, for example by interfering with accounting rules and applying un-stressful stress tests to bank balance sheets.
None of this addresses the underlying problem: the over-indebted consumer will be a saver for years to come; there are therefore no end-buyers to fuel economic growth. This is the paradox the optimists avoid: you cannot get consumers to consume when they are maxed-out. The psychology has changed, debt has to be paid down and money saved.
So inevitably GDP growth will be worse than forecast by the CBO, and the government deficit will be substantially greater, since any downturn is ruinous to government finances. Furthermore, the financial crisis itself is not over, with the delights of securitised commercial property, credit card debt, corporate failures and other yet-to-be-revealed surprises still ahead of us. Some of these commitments may be financed by Bernanke’s passing helicopters but most of the funding will have to be through Treasuries.
The global nature of the credit crunch will lead to lower trade imbalances as consumers everywhere struggle with their debts, and therefore there will fewer natural foreign buyers of US debt. The more the government bond market relies on foreign investors, the higher the yields will have to be, so the ability of consumers to buy this debt is central to the outlook for bond yields and for the dollar. One way to assess the likely scale of debt issuance is to look at history, and here a paper by Carmen Reinhart and Ken Rogoff is useful:
“We find that banking crises almost invariably lead to sharp declines in tax revenues as well significant increases in government spending (a share of which is presumably dissipative). On average, government debt rises by 86 percent during the three years following a banking crisis. These indirect fiscal consequences are thus an order of magnitude larger than the usual bank bailout costs that are the centerpiece of most previous studies. That fact that the magnitudes are comparable in advanced and emerging market economies is also quite remarkable.”*
This implies that for 2009 – 2011, the deficit will increase by 86% to about $9 trillion, compared with the $2.4 trillion in the CBO forecast. We may regard this as a conservative estimate, since the current financial crisis is much worse than the historical average, and is potentially even worse than that of the 1930s. Furthermore, these deficits will continue beyond 2011 as the biggest consumer debt bubble in history is unwound. The Catch-22 is that without the consumer, there is no recovery, and if the debt is to be financed, the consumers will be too busy saving to consume.
It gets worse. Consumers and their savings vehicles currently own only $2.8 trillion of the outstanding government debt, about one third compared with the $9 trillion to be raised. Foreign governments and international investors hold $3.13 trillion, the result of past trade deficits. To finance the $9 trillion deficit, consumers are going to have to accelerate their savings at an unprecedented rate. It is almost inevitable that the marginal buyers, who always price markets, will be the diminishing pool of foreigner investors. The deflationary effect on consumption of all this saving is on such a scale that government deficits can be expected to continue at over $3 trillion annually for a further 2 or 3 years, giving a total funding requirement outturn of $15-20 trillion. This is very different from the CBO’s estimates.
The economic effect of the switch of, say $15 trillion, from consumption to savings can be guessed at. This is over 100% of US GDP that will be diverted over six or seven years from straight gains in GDP to gains through government distribution. The government redistributes this economic potential inefficiently, loosing much of the economic benefit on the way: this is a factual comparison between pure economic motivation and political motivation coupled with bureaucracy. If we generously assume that these inefficiencies loose only 40% of the economic benefit, that equates to nearly 7% per annum loss of real GDP growth potential. Talk to the Russians about the benefits of economic redistribution by the state; they will tell you, “Catch-22”.
Of course, the US will try to wriggle out of these Catch-22s. Unfortunately, confidence tricks that have been tried in the past on the proletariat become progressively less successful. Wrinkles such as quantitative easing will have their limitations, because they undermine the currency, escalating the stagflation risk. We may expect the central banks to bolster their foreign currency reserves through swap agreements, but anyone with memories of the sixties and seventies will smell a long-dead rat, and dub this “printing money for export”. Compounding the problem will be similar challenges to the Reinhart and Rogoff 86% rule in the other major currencies. The challenge for the Conspiracy of Central Bankers will be for all their fiat currencies to sink at the same pace, giving an illusion of stability so no one will notice and none of them can be blamed.
This is the likely explanation behind rising bond yields and dollar weakness. Central bankers who have sold substantial amounts of gold to keep the price down must be bedevilled by nightmares. Zhou Xiaochuan, Governor of the People’s Bank of China appears to have already worked this out to the embarrassment of his capitalist counterparts.
*”Banking Crises: An Equal Opportunity Menace”, C M Reinhart and K S Rogoff, Dec 2008